chapter 4

• asset transformation theory

  Highlights the mismatch of maturity preferences between lenders and borrowers. Lenders typically desire readily accessible short-term funds whereas borrowers often require long-term fincacing for investment purposes. FIs bridge the gap through maturity transformation, liquidity transformation, size transformation and risk transformation
• Maturity transformation

  banks make long-term loans and finance them by issuing short-term deposits
• Liquidity transformation

  lending long-term, financing through short-term deposits
• Size transformation

  amount provided by the lenders is smaller than amount required by borrowers , FIs collect the small amts and parcel them into larger amts for borrowers
• Risk transformation 


  deposits are relatively safe in banks
• Liquidity insurance theory

  address the need for readily available funds during unforeseen circumstances. FIs act as a pool of liquidity, offer deposit holders ability to withdraw funds easily and borrowers an uninterrupted access to credit. Also known as "consumption smoothing" Allow individuals and businesses to manage their cash flow fluctuations and unforeseen expense
• Transaction cost reduction theory

  Economies of scale and scope allows FIs to standardise loan process, develop extensive branch networks and leverage economies of scale to reduce transaction costs per unit of output. This translates to lower borrowing costs for businesses and consumers. Additionally, FIs can internalise transaction costs by screening loan applicants, mointoring borrowing behaviour and enforcing loan agreements.
• Asymmentric information 


  one party hv less info than the other
• Adverse selction

  (Before) Borrowers hv more info than lenders. Occurs when borrowers w a high risk of default are more likely to seek loans. FIs mitigate this problem by employing credit screening techniques and requiring collateral which discourages high-risk borrowers form applying.
• Moral Hazard

  (After) Borrowers exhibits risky behaviour after receiving a loan,knowing FIs bear the risk. His address this through loan covenants that restrict borrowers activity and ongoing monitoring, to ensure responsible use of borrowed funds
• Reduce moral hazards in debt markets

  This is done by making debt contracts incentive-compatible. This increase the stake of borrowers own net worth, so they will use funds responsibly. Mointoring and enforcing covenants, this restricts borrowers activity. FIs can screen and monitor as they do not face free-rider problem.
• Reduce moral hazard in equity markets

  Stockholder can monitor firm activity but expensive and will face free-rider problem. Government can intervene, impose regulation to adhere to standard accounting principle or impose laws of stiff criminal penalties but hard to discover frauds so not effective. Venture capital firms can avoid free rider problem where it allows entrepreneurs to start businesses and in exchange for shares. Debt markets require borrowers to pay a fixed deposits and let them keep the profits.
• delegated monitoring policy

  Monitoring is expensive so banks should do it due to their diversification. To work needs economies of scale, small capacity of investors and low cost of delegation. Solves moral hazard through monitoring or designing a debt contract.
• changing trends in banking

  Reduction in cost advantages in acquire funds and reduction in income advantage using funds
• reduction in cost advantages consequences 


  a disintermediation process: low I/r, investors take their deposits out of banks and look for higher-yielding investment opportunities. Money market mutual funds appeared and grew dramatically in USA 1980. issued by FIs to raise funds to be invested in short term money mkt securities, investors get interest payments. Deregulation in 1980, increase banks competitiveness in acquiring funds at a higher cost.